Volatility strikes back
11 October 2018 | Investing
When volatility returned to global equity markets earlier this year, headlines cast this statistical concept in its familiar role as investors' most fearsome enemy.
But volatility may be getting a bad rap. It's not a villain, and it's not always synonymous with portfolio losses.
A closer look at the concept can help us understand what volatility is, why we shouldn't expect a premium for holding equities without it, and how advisors can help investors manage their emotions when volatility takes center stage.
Volatility is not directional
A common misconception about volatility is that it implies direction and that, therefore, lower volatility is preferable to higher volatility. In reality, market volatility metrics are simply measures of dispersion around the average return, providing no insight into direction. A used automobile is an incredibly low-volatility asset in that it steadily declines in value over time; that doesn't make it a good investment. In fact, outside of the mobility benefits it provides its owner, it is the very definition of a poor one.
An investment's recent returns determine whether volatility marks a change for the better or the worse. In recent years, equity prices have marched steadily higher. In this situation, a few instances of negative returns will have a larger impact on volatility metrics than will positive returns of the same magnitude. By contrast, during a period of steady equity market declines, a few days of positive returns will produce a spike in volatility. The figure below demonstrates how two different portfolios with opposite performances can produce identical volatility measurements.
Two portfolios, identical volatility
Notes: Figure shows hypothetical return simulations for two portfolios. Volatility is calculated as the 10-day rolling standard deviation of daily returns. Source: Vanguard.
As you might expect, the longest continuous period of above-average market volatility1 since the Great Depression occurred during the 2008 global financial crisis. What you might not expect is that if you bought the S&P 500 Index at the peak of its volatility (November 21, 2008) and held it until volatility fell back below its historical average nearly a year later (September 28, 2009), you would have earned a 33% return, even before accounting for dividends.
Ignorance (toward volatility) is bliss
Investors must remember that short-term volatility is the price for long-term outperformance.
Historical data show that over long periods, investors are compensated for holding riskier assets with higher returns than those of less risky assets. Daily account balances may start demonstrating larger fluctuations than in recent years, but long-term investors must resist the urge to make impulsive changes to their investment plans. As Nobel laureate Daniel Kahneman said, "If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea. It's the worst possible thing you can do."2 Mathematics explains why.
As mentioned above, stock market volatility explains how often and by how much equity returns differ from their average value. The mechanics of the calculation mean that while investment returns increase in proportion to time, volatility increases more slowly—in proportion to the square root of time.3
The upshot is that the less frequently investors peek at their portfolios, the less likely they are to see a loss and, potentially, feel fear and regret. The table below demonstrates this phenomenon using daily S&P 500 Index returns. Notice how returns grow at a faster rate than standard deviation of returns, a.k.a. volatility, and that as time goes on, the likelihood of realizing a positive return increases.
|Time horizon||Median return||Standard deviation of returns||Positive return probability|
Sources: Vanguard calculations, using data from Bloomberg. Dates: January 4, 1988–February 16, 2018.
Once again, this highlights the importance of a long-term focus when investing, as any single day offers just better than a 50% chance of positive returns. Investors who ignore short-term volatility and follow a disciplined investment plan will realize that when it comes to long-term returns, time is on their side.
1 Volatility in this example is defined as the rolling 30-day standard deviation of price returns for the Standard & Poor's 500 Index, with the historical average taken from March 1928 through February 2018.
2 Zweig, Jason. "Do You Sabotage Yourself?" Money magazine (May 2001): 78
3 The square-root-of-time rule is a useful, but not perfect, method for scaling volatility. Observed data differ from the model's assumptions of normally distributed returns and zero mean value.
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